If you find yourself facing an investment-related tax bill in 2024, you might want to consider exploring tax-exempt investment options for the future. In this article, we will discuss various types of bond investments that offer interest payments exempt from federal and/or state income tax, and are typically available in many brokerage accounts.
It’s important to note that the tax exemptions mentioned here only apply to the income received by holding bonds until maturity. If you sell a bond before maturity at a higher price than what you paid for it, any profit may still be subject to capital gains tax.
Municipal bonds
Municipal bonds, also known as “munis,” are issued by states, cities, counties, and other local governments to finance public projects like school and bridge construction.
Interest on municipal bonds is exempt from: Federal income tax, and in some cases, state income tax depending on the bond’s origin and where you reside.
Most states do not tax their own municipal bonds, and some states do not have a state income tax at all, making muni bond interest completely tax-free. Residents of the District of Columbia also do not pay local income taxes on any muni bonds, and muni bonds from non-state U.S. territories like Puerto Rico are free from state taxes in all states.
However, interest payments on muni bonds that fund business-like projects such as stadiums and airports may be subject to the alternative minimum tax (AMT) in some cases.
While muni bonds often offer higher yields than Treasury bonds, there is a higher risk of default as local governments may fail to meet their debt obligations. It’s essential to be aware of call risk and potential price fluctuations based on interest rate changes if you choose to invest in muni bonds.
Available in: Certain brokerage accounts. Some brokers may not offer individual muni bonds, so it’s important to research their investment options if you are interested in purchasing them.
Here is a list of brokers reviewed by BW that provide individual muni bonds:
Tax-exempt bond funds
For a more straightforward approach to adding muni bonds to your portfolio, consider investing in a tax-exempt bond fund. These funds typically invest in muni bonds and are available as mutual funds or exchange-traded funds (ETFs).
Some tax-exempt bond funds focus on munis from specific states like New York, offering residents tax-exempt interest payments at both the federal and state levels.
Interest on tax-exempt bond funds is exempt from: Federal (and sometimes state) income tax. Some funds advertise themselves as “AMT-free,” meaning they avoid muni bonds that could trigger AMT liability.
However, fund managers have discretion over their investments, and some funds may occasionally include assets that are subject to federal income tax or AMT. It’s crucial to review the fund’s details before investing.
While funds containing muni bonds carry similar risks to individual muni bond investors, the diversification within a bond fund helps reduce these risks for shareholders.
Available in: Nearly all brokerage accounts. While some accounts may not offer mutual funds, tax-exempt bond ETFs are widely available in brokerage accounts that support ETF trading.
Treasury bonds, bills, and notes
The U.S. government issues Treasury securities of various durations to borrow money. Treasury bonds typically have durations of 20 years or more, while notes range from 2 to 10 years, and bills are shorter-term securities.
The U.S. government is considered one of the most reliable borrowers globally, with a low likelihood of default on Treasuries despite occasional credit rating downgrades and political debates over funding and the debt ceiling.
Available in: Most brokerage accounts. Treasury securities are typically offered in accounts that support individual bonds, and some platforms even provide automated Treasury accounts for investing in T-bills.